Great Funds for Income in Retirement

published 14 April 2016

Ah, retirement. No more deadlines, endless meetings or conference calls—you’re finished with the working life. But that also means no more paycheck. Now one of your biggest financial worries is how to convert your nest egg into an income stream.

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These days, Target Retirement Income holds five funds, four of which are the firm’s biggest index funds: Total Stock Market (VTSMX), Total Bond Market (VBMFX), Total International Stock Market (VGTSX) and Total International Bond Market (VTIBX). The fifth fund is Vanguard Short-Term Inflation-Protected Securities Index Fund (VIPSX), an actively managed bond fund that invests in Treasury inflation-protected securities. All told, Target Retirement Income has 70% of its assets in bonds and 30%% in stocks. It returned 5.2% annualized over the past 10 years, and it currently yields 2.0%. (Returns and yields are as of April 11.)Risks: Though retirement income funds are conservative, they are vulnerable to all the usual risks associated with owning stocks and bonds.

What they are: Shares of companies with a long track record of consistently raising their dividends. Stocks in these kinds of firms have held up better than Standard & Poor’s 500-stock index in past market downturns, according to a new study by David Mazza, at State Street Global Advisors. And although stocks with rapidly expanding dividends aren’t usually the biggest yielders, they do provide some income.

Our favorite dividend-growth mutual fund is Vanguard Dividend Growth (VDIGX), a member of the Kiplinger 25, the list of our favorite no-load, actively managed mutual funds. Manager Donald Kilbride invests in high-quality firms that he thinks can and will raise their dividends over time. Over the past 10 years, Dividend Growth returned 8.7% annualized, compared with 7.0% annualized for the S&P 500. The fund yields 2.0%.

Among ETFs, we like Schwab US Dividend Equity (SCHD), which invests in 100 firms that have paid dividends for at least 10 years and rank well with respect to several fundamental factors that measure a company’s soundness, including dividend yield and five-year dividend growth. The fund, which is a member of the Kiplinger ETF 20, the list of our favorite exchange-traded funds, yields 3.1% and charges just 0.07% in annual expenses.

We like a couple of ETFs for delivering income from preferred stocks. One is iShares US Preferred Stock (PFF), a member of the Kiplinger ETF 20 that holds 279 preferred securities. But banks and other financial firms account for 60% of the ETF’s assets. The fund’s top holdings are preferreds issued by Allergan, HSBC Holdings and Barclays Bank. U.S. Preferred Stock, which charges 0.47% annually, yields 5.6%.

There are few no-load mutual funds that focus solely on preferred stocks, but with American Century Equity Income (TWEIX), a member of the Kiplinger 25, you’ll get a mix of high-quality dividend-paying stocks as well as a small slice of preferred stocks (11% of assets at last word). One of the fund’s biggest holdings is a Wells Fargo preferred stock that yields a whopping 6.2%. Equity Income, which yields 2.1%, returned 7.0% annualized over the past 10 years. That matches the return in the S&P 500, but the fund achieved its results with about one-third less volatility than the index.

What they are: Sometimes referred to as Ginnie Maes (or GNMAs, for Government National Mortgage Association bonds), these are mortgage-backed securities whose principal and interest payments are fully guaranteed by Uncle Sam. Government-guaranteed mortgage-backed securities—and funds that invest in them—offer a better yield than comparable Treasury securities. For example, Vanguard GNMA Fund (VFIIX) and T. Rowe Price GNMA Fund (PRGMX) yield 2.3% and 2.1%, respectively. A comparable Treasury would yield 1.5% these days. What’s more, these two funds charge below-average to average expense ratios. Vanguard GNMA costs 0.21% in annual fees; the T. Rowe Price offering charges 0.59% a year.

What they are: Bonds issued by companies with investment-grade credit ratings (triple-B or better). At RBC Wealth Management, says Darla Kashian, a financial adviser with the firm, the typical retired client holds 30% of assets in short-term investment-grade corporate debt. The high-quality bonds serve as a buffer from market volatility for the rest of the portfolio, which is typically invested in dividend-paying stocks.

Our favorite short-term bond mutual fund is Vanguard Short-Term Investment Grade (VFSTX). The fund, a member of the Kiplinger 25, doesn’t invest only in corporate debt. Manager Greg Nassour has half of the portfolio in corporates; the rest is in cash, Treasuries, and asset- and mortgage-backed bonds. But the short-maturity focus means the fund is somewhat sheltered from the damage of rising interest rates. The fund’s average duration of 2.6 years implies that if interest rates were to rise by one percentage point, the fund’s share price would decline by 2.6%. That, of course, would be offset by the fund’s interest payments—the current yield is 1.8%. Annual fees are a low 0.20%.

Generally, the longer a bond’s maturity, the greater its yield and the greater the interest-rate risk. Exchange-traded Vanguard Intermediate-Term Corporate Bond ETF (VCIT), which charges the same amount as its shorter-term ETF sibling, has nearly half of its assets in triple-B-rated corporates and yields 3.2%. But the ETF’s average duration is 6.5 years—double that of Vanguard Short-Term Corporate Bond ETF.

Our top pick among junk bond mutual funds is Vanguard High-Yield Corporate Fund (VWEHX). One of the tamer funds in this category, it sticks with debt in rating tiers just below investment grade. Nearly half of its assets are in debt rated double-B, the highest junk rating, and only 8% are in bonds that are unrated or rated below B. Manager Michael Hong has been in charge since February 2008. Since then, High-Yield Corporate has returned 6.8% annualized, which beats the typical high-yield bond fund by an average of one percentage point per year. The Vanguard fund, a member of the Kiplinger 25, yields 5.5% and charges 0.23% a year.

Risks: Issuers of junk bonds stand a higher chance of defaulting on their debt than issuers of investment-grade bonds, explaining why junk issuers have to pay more interest than high-quality firms do. Junk bonds are also more sensitive than high-grade bonds to investor perceptions about the health of the overall economy. When investors fret about recessions, prices of junk bonds typically fall because of concerns that high-yield-debt issuers will have trouble meeting their obligations in a sagging economy. After a rough start in 2016, junk bonds have rebounded lately as recession fears have dissipated.

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Nellie joined Kiplinger in August 2011 after a seven-year stint in Hong Kong. There, she worked for the Wall Street Journal Asia, where as lifestyle editor, she launched and edited Scene Asia, an online guide to food, wine, entertainment and the arts in Asia. Prior to that, she was an editor at Weekend Journal, the Friday lifestyle section of the Wall Street Journal Asia. Kiplinger isn't Nellie's first foray into personal finance: She has also worked at SmartMoney (rising from fact-checker to senior writer), and she was a senior editor at Money.